REIT Improvement Act In Congress

May 16, 2003
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WASHINGTON, D.C. — Legislation that would make a number of small improvements to the existing Real Estate Investment Trust tax rules has been introduced in the U.S. House of Representatives.

Representatives Jim McCrery, R-LA, and Ben Cardin, D-MD, were joined by 25 other members of the House Ways and Means Committee in introducing the REIT Improvement Act of 2003 (H.R. 1890) late last month.

Companion legislation is expected to be introduced in the U.S. Senate soon.

According to Steven A. Wechsler, president and CEO of the National Association of Real Estate Investment Trusts, the principal goal of the legislation is to clarify and correct some issues surrounding the REIT Modernization Act of 1999.

Wechsler said the bill would eliminate a discriminatory barrier to foreign investment in publicly traded U.S. REITs and also would give the Internal Revenue Service the ability to impose monetary penalties for reasonable cause violations of REIT tests in lieu of denying REIT status.

Wechsler said that, as has been the case with past REIT-related legislation in Congress, the RIA has broad bipartisan backing.

Congress originally adopted legislation permitting the creation of REITs in 1960, the idea being to enable small investors to have a share of large-scale real estate holdings. Congress decided that the only way for modest investors to access investments in significant commercial properties was through pooling arrangements.

As a result, Congress designed REITs to unite the capital of many investors into a single economic enterprise. That enterprise was geared to the production of income through commercial real estate ownership and finance.

Congress’ intent also was to make REITs liquid so that investors could buy and sell shares of diversified portfolios — from shopping malls to apartment complexes.

For more than three decades, however, REITs played a very limited role in real estate investment because they were not allowed to be involved in the income-producing aspects of real estate — rental and management service revenue.

Because REITs were permitted only to own real estate, not operate or manage it, they had to find third parties — whose economic interests might diverge from those of the REITs’ owners — to operate and manage the properties.

The investment marketplace did not readily accept this arrangement.

During those same decades, the tax code’s provisions also distorted the real estate marketplace by orienting real estate investment to tax sheltering.

By using high debt levels and aggressive depreciation schedules, a taxpayer could take interest and depreciation deductions that significantly reduced his or her taxable income. In many cases these deductions led to so-called paper losses used to shelter a taxpayer’s other income.

By contrast, Congress had designed REITs specifically to create taxable income on a regular basis, and did not permit REITs to pass losses through to shareholders. Therefore, for many years the REIT industry could not compete effectively for capital against tax shelters.

hat’s what started to change in the 1980s.

Wechsler explained that the Tax Reform Act of 1986 radically changed the real estate investment landscape in two important ways.

First, the Act drastically reduced the potential for real estate investment to generate tax shelter opportunities. It did so by limiting the deductibility of interest, lengthening depreciation periods and restricting the use of so-called passive losses. This meant that real estate investment had to be economic and income-oriented.

Second, as part of the Act, Congress gave a broad new scope to REITs. The Act permitted REITs not only to own real estate, but also to operate and manage most types of income-producing commercial properties.

This meant REITS were permitted to provide customary income-producing services associated with real estate ownership.

Finally, for most types of real estate — other than hotels, health care facilities and some other activities that require a higher degree of personal services relative to rent — the economic interests of the REIT owners could align with those of the REIT operators and managers.

Simply stated, a REIT today is a company dedicated to owning and, in most cases, operating income-producing real estate, such as apartments, shopping centers, offices and warehouses. Some REITs also are engaged in financing real estate.

Within the past decade, the equity market capitalization of REITs has increased over 15 times.

To be a REIT, a company must pay 90 percent of its taxable income to its shareholders every year.

A REIT may deduct the dividends paid to the shareholders from its corporate tax bill so long as:

  • Assets are primarily composed of real estate held for the long term.

  • The company’s income is mainly derived from real estate.

  • The company pays at least 90 percent of its taxable income to shareholders.

The main benefit of being a REIT is that it sustains only one level of taxation. The main limitation is the restriction on the percentage of earnings the company may retain.

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